Don’t let emerging markets be an investment blind spot

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There has been an evolution in emerging markets and we think they deserve a place in your global equity portfolios.

A well-rounded, diversified approach should be at the core of a global equity portfolio, and emerging markets are one key piece that shouldn’t be ignored or overlooked. We’ve asked Phil Langham, RBC Global Asset Management’s head of emerging markets equity, why investors should take a fresh look at emerging markets. He sees appealing long-term growth potential, as well as attractive trends and drivers of emerging market performance in 2018 and beyond that help the asset class stand out.

There have been major changes in emerging markets over the years. Why should investors take a closer look?

The key reason for taking a closer look is the high growth that emerging markets (EMs) offer. In 1985, emerging markets represented something like 35 percent of global GDP. That’s now grown to around 57 percent.

We can expect its share of global GDP to continue to increase because emerging markets still account for over 70 percent of global GDP growth. The factors driving that increase are the ability to catch up in terms of technology, demographics, lower credit penetration, and lower GDP penetration.

This is also reflected in a growing market value. In 1996, the market capitalization or value of emerging market equities was around 10.7 percent of the global share. It is now around 21 percent, and is expected to grow to about 39 percent in the year 2030.

GDP per capita in emerging markets is a fraction of what it is in developed markets, so there is still a lot of catch-up potential.

Global EM equity weight progression (%)

Emerging market equities are becomingtoo big to ignore.

Source - National research correspondent; February 2016

On a sector basis, are there trends that make emerging markets more investable than they were years ago?

We have seen quite a substantial improvement in the quality of the indexes. Commodity sectors, such as Energy and Materials, represented about 40 percent of the MSCI Emerging Markets Index 10 to 15 years ago. That’s now down to less than 15 percent. Information Technology, which was about 15 percent, has now virtually doubled to almost 30 percent. Consumer sectors have also grown. These sectors tend to be higher quality and offer higher return on equity.

This shift is why the commodity-heavy Canadian market is no longer a good proxy for EM equities. The correlation between EMs and the Canadian market has declined and is now really no different than with other markets.

In thinking about 2018 and beyond, how do the key drivers of emerging market equities stack up?

We’ve found that there are three factors that tend to drive future performance.

The first is currency. Our feeling is that even if the U.S. dollar strengthens, there are actually a lot of reasons why EM currencies can perform well against the dollar.

EM currencies look undervalued based on a wide range of different measures. They are also supported by positive real interest rates, unlike some developed markets, and a dramatic improvement in fundamentals. Over the last few years, we’ve seen current account deficits moved to surpluses. We’ve seen growing currency reserves and improvements in growth. Even in China we’ve seen one of the biggest capital outflow threats from a year ago turn to capital inflows.

The second driver is economic growth, and particularly growth relative to developed markets: When the gap between EM and developed market GDP growth is expanding, it tends to drive EM outperformance. Conversely, EM underperformance has been driven by poor relative growth versus developed economies.

Developed vs. emerging economies real GDP growth

The International Monetary Fund is forecasting that the growth gap is going to continue to increase. And we feel that that’s likely to go on being the case because most reforms we’re seeing in these economies are leading to improvements in growth. Virtually every EM country is seeing an improvement in its political landscape and in its economic management.

And the third factor that drives EM performance is the earnings and return on equity cycle.Over time, return on equity in emerging markets tends to fluctuate a lot; it tends to be quite cyclical. The main contributor to return on equity is profit margins. Margins were weak from 2010 to 2016 due to poor productivity and overcapacity, but the cycle has now turned. We feel that over the next five or six years, the margin improvement that we expect to see can lead to quite sustainable earnings growth in emerging markets of about 10 percent to 15 percent per year.

What about valuation? Can it be used as a gauge of future performance?

What we’ve seen historically is that valuation only tends to be a good guide of future performance at extremes. So, for example, when the price-to-book (P/B) ratio is below 1.3 times (cheap) or above 2.4 times (expensive), this is a strong indicator of where future performance will be.

Currently, EM valuations are smack in line with the long-term averages but are trading at quite a decent discount to developed markets in both P/B and price-to-earnings (P/E) terms. The discount is around 27 percent. When you’re pretty much in the middle of long-term averages as we are now, then valuation doesn’t tend to be a good guide in terms of what drives future performance.

Emerging markets outlook

GDP growth differential has been a driver ofrelative performance vs. developed markets.

Source - FactSet, Datastream, Bloomberg, national research correspondent; data as of December 2017

What are some of the common characteristics of the EM companies you invest in?

We’re focusing on companies that have sustainably high cash flow on invested capital and therefore offer excess shareholder returns. We found that the main factors that lead to the sustainably high cash flows and return on investment are strong management and industry dominance.

We also evaluate companies within a framework of long-term investment themes. Currently, we’re focusing on the themes of domestic consumption, deposit franchises, digitalization, health & wellness, and infrastructure.

The important thing about these themes is that they really allow us to get away from the constraints of the index benchmark, which includes typical country and sector over- and underweights. From a top-down macro point of view, the themes really position the portfolio in areas of long-term sustainable growth.

One other aspect we feel is very important is to evaluate firms based on environmental, social, and governance (ESG) characteristics. Companies that pay attention to ESG tend to have a strong culture of excellence and therefore don’t face the same problems as competitors. They’re companies where employees and management tend to be much more engaged and therefore much more productive, and these are all factors that lead to higher and more sustainable returns.

As we think about categories of EM stocks, are there some distinctions that stand out?

We believe that EM small caps are an interesting asset class. One quite surprising fact is that there is a huge choice of emerging market small-cap stocks. There are over 7,000 small caps and they make up 94 percent of the EM stock universe. There are only about 500 large- and mega-cap stocks.

Another thing that may surprise investors is the unusual phenomenon in EM small caps of high returns but lower risk, which differs in developed markets where small caps have high returns and higher risk. So with EM small caps you have lower volatility, a lower beta, and a lower correlation with the MSCI World Index. Another important factor supporting EM small caps is faster growth.

With so many small caps and a growth orientation, do dividends play much of a role in emerging markets?

People generally don’t view EM stocks as being ways to play dividends, or don’t see dividends as a way to play EM stocks. But actually there are even more companies in emerging markets that pay dividends, roughly 83 percent, than there are in developed markets, which has about 78 percent. And EMs are doing this on a much lower payout ratio. The faster earnings growth supports very fast dividend growth in emerging markets. I think it adds to the attraction of this area.

EM corporate capacity to pay dividends is strong

Payout ratio ([dividends per share / earnings per share] x 100)

After a decade of very strong growth, EM companies areuniquely positioned to increase payouts.

EM portfolio managers have a large number of companies to choose from that have dividend yields above 3 percent. There are around 900 stocks in that category. And unlike what we see in the developed world where high dividend payers are generally concentrated in the more mature sectors like Telecom and Utilities, what we see in emerging markets is that dividend stocks cover a wide range of different sectors and countries.

Finally, could you address the elephant in the room? China is a big part of the emerging market space. What are your thoughts about the risks there?

I think there are risks to growth in China, but I don’t think there are meaningful risks to the Chinese equity market.

What we generally see in China is a tradeoff between reforms and growth. Essentially, the authorities are keen to continue their reform program but also still have an eye on growth. I think they probably have too much of an eye on growth, and I’d be more comfortable if we saw slightly slower growth but more progress on reforms—more puncturing of asset bubbles, cutting back on credit growth, and anti-corruption efforts. But things in China tend to move relatively incrementally.

A lot of reforms that we’re seeing are positive and in particular we’re seeing capacity being taken out of industries where overcapacity has been a massive drag for several years. As a result, the banking system is gradually being cleaned up.

We’re reasonably positive on the macro environment in China. We do think that corporate governance is improving and that we will find more investment opportunities in China in the future.

Non-U.S. Analyst Disclosure: Phil Langham, an employee of RBC Wealth Management USA’s foreign affiliate RBC Global Asset Management Inc., contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since he is not an associated person of RBC Wealth Management, he may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.

In Quebec, financial planning services are provided by RBC Wealth Management Financial Services Inc. which is licensed as a financial services firm in that province. In the rest of Canada, financial planning services are available through RBC Dominion Securities Inc.

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